Charts of the Month - June '23

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The Big Turnaround in Japanese Equities

The lead story in last week’s Research publication was going to be the big turnaround in Japanese equities, but that was before Yevgeny Prigozhin decided to take a joyride up the M-4 towards Moscow threatening to overthrow the government of the Russian Federation.

Fair enough, it was a pretty important event, so it took the top slot. (Go have a read of the report in its entirety here.)

So Japan got knocked to the second place story, however, I’m reviewing it here as it’s still well worth your time.

Briefly, the “Tokyo Stock Exchange has recently announced the single most important initiative in over a decade that could boost Japanese equity markets, and investors are taking notice.”

What’s happening?

Japanese companies are notorious for hoarding cash on their balance sheets.

Accumulating cash can be the prudent move to build a defensible balance sheet capable of weathering recessions, black swan market events, or to be opportunistic with M&A when something of value presents itself.

But cash hoarding has its downsides as well.

Investors invest in businesses so that they’ll put that cash to work for them. If a company doesn’t use that cash to invest in capital projects (build the assets on the balance sheet which should create incrementally more cash in the future), they typically will redistribute that cash back to investors in the form of dividends and/or share buybacks. None of which Japanese companies are particularly known for.

Investing in capital projects with a positive IRR is preferable. Redistributing cash back is secondary. But sitting on large amounts of cash and doing nothing with it is not acceptable.

The Price-to-Book Ratio (P/B)

• Cash on a company’s balance sheet increases its ‘Book’ value (the denominator in P/B).

• The ‘Price’ (numerator) is what the company trades for in the open market. Price is determined by what investors believe the intrinsic value of the business is, primarily assessed as its ability to generate future cash flows with the assets sitting on the balance sheet.

• Cash is a non-productive asset, which means it does not generate future cash flows. Therefore, cash must be put to work (purchase assets) to generate a higher ‘P’.

So, a company that hoards cash will likely have a larger B, and likely a smaller P, resulting in a P/B that is low relative to their peers that invest that cash in productive assets. Yes, this is a simplification of how it all works, but is directionally correct.

The combination of the above has resulted in a Japanese stock exchange full of companies with P/B ratios significantly below that of their U.S. and even European counterparts.

The Japanese Stock Exchange is NOT happy with this. So much so that they’ve (again simplifying here) told companies that are listed on the exchange to implement measures to increase their P/B ratios to greater than 1, or else they will be delisted. This is a BIG deal.

They must either begin allocating cash back to shareholders and/or put in place plans to increase their Return on Capital Invested – both of which should increase the cash flow profile of the businesses, with the goal of raising their stock price.

The magnitude of this order cannot be overstated. The Japanese stock market has already been performing historically well as of late, and if the desired outcome of these changes materializes, a re-racking of Japanese equities significantly higher is not out of the question.

We’re quite bullish Japan.

Full analysis is available here.

Apple Liquidity

Now, on the other side of the capital allocation coin, there’s Apple.

For some context, since 2013, Apple has bought back $582 billion worth of its own stock. The largest S&P500 ETF is the SPY, which has a total market cap of $407 billion (as of 6/27), with Apple, the largest holding in the ETF at 7.5%, representing about $31 billion of that total. In 10 years, Apple has bought back more of its own stock than the entire market capitalization of SPY.

Going a layer deeper and marrying the above with the ‘passive flows into market cap weighted indices’ theme which we’ve covered extensively in the past (building off the work of Mike Green), there is a self-fulfilling prophecy taking place on the largest scale imaginable.

Here’s Mike on the latest Grant Williams and Bill Fleckenstein podcast:

“So just a really simple example, the largest stock by market cap we all know is Apple… when you look at Apple’s market cap, somewhere in the neighborhood of $2.5 trillion, its market capitalization is roughly 100x larger than the smallest stock in the S&P 500, but its liquidity is only about 5x more. So just like we talked about with the dynamics around the dotcom cycle where you had this weird component of market cap weighted indices and stocks like Microsoft had far fewer shares available, now that’s being replaced by the dynamics of every time Vanguard or BlackRock or any passive entity shows up to buy the index on behalf of their investors, that purchase in turn is distorting the market by putting far more demand into Apple or Microsoft relative to the liquidity versus say a Delta Airlines, for example… That causes pressure upwards on the S&P 500 in that passive framework and pushes up the largest stocks. That’s then augmented further by the giant buyback programs of Microsoft, Apple, etc.”

Liquidity is the key component here.

With the massive buyback programs in place over the last 10 years, Apple’s shares outstanding are down to a 23-year low (before the .com bubble).

Buybacks + Passive Flows = non-linear growth in share price due to decreased liquidity (shares outstanding).

This is the self-fulfilling prophecy.

If the capital allocation decision for management teams is to choose the path with the highest IRR, and management knows there’s a consistent and large bid for their stock (passive flows) and the more stock they take out of the market (buybacks) reinforces the passive flows by reducing liquidity (i.e. larger bids for smaller liquidity pools), why would they ever allocate capital to a new widget plant or some other project that takes years to build and has an uncertain return profile? It’s hard to turn down the route that has proven so successful over the last decade (Apple’s share price is up 845% over that time frame).

This isn’t to say that Apple isn’t a great operating company because they are (they’re likely the greatest product company in history). They’re just doing an amazing job of leveraging that excellence in product and operations (=generating a ton of cash flow) and allocating that cash in an even more efficient manner (buybacks).

It’s a perfect short-term strategy. A pretty good medium-term strategy. Long-term however, new cash flow is always required, and is a lot more difficult to come by.

No, I’m not short Apple, and never will be.

European Natural Gas

Here we go again...

As reported by Oilprice.com on June 26th, “Europe’s LNG Imports Surpass Gas Imports for First Time Ever”.

Yes, we’re in the middle of another European summer and yes, I’m heading to meet my very European co-founder in Copenhagen in a few weeks (give us a shout if you’re in town), but this is a reminder that (I don’t care how outdated this quote is), Winter is Coming.

LNG, which is significantly more capital intensive, more complex from an engineering perspective, and has much longer lead time than its once very reliable brethren, piped natural gas, has become a critical import for all continental Europe, and will increase in terms of criticality with every month that passes.

To the chagrin of any European who loathes their reliance on the U.S. for anything (looking at you Macron and Diego), relying heavily on the U.S. for their ability to heat their homes, grow their food, and for every industrial process that runs the bloc, the above chart is not something they take lightly. And rightfully so.

Unfortunately, this is the EU’s reality for the foreseeable future.

This is even less fortunate when you consider that the U.S. is still playing political games with their fossil fuel future.

A positive story that broke a few weeks back, that of the approval for the Mountain Valley Pipeline, needs to be taken with a grain of salt. Pipeline infrastructure, which allows gas to be moved across the country and to terminals for liquification, and eventually shipped to our friends across the pond, has been severely lacking for many years now, resulting in 2022 being the lowest level of pipeline building to take place since at least 1995 (as far back as the data goes).

The inability to move the gas may be a partial explanation for the below chart:

If you can’t move the stuff, why even pull it out of the ground?

If Europe is going to be importing LNG for some time to come (they are), then they’re going to need reliable partners to buy it from. The U.S. is now 50% of their LNG imports, and I’m sure they’d like to cover that 19% still coming from Russia and have a bit of buffer for a ‘just in case’ gulf hurricane or geopolitical event that knocks any amount of supply offline.

Europe and the U.S. need to get serious. Now.

Because seeing the price of an Aperol spritz rise to $15 limits me to ~10 per night if I skip breakfast. And that’s not the summer vibe I’m flying halfway around the world for.

Some interesting anecdotes to think about:

• Steven Wilkinson wrote a great piece for us awhile back, Mittlelstanding Together, where he talks in-depth about the heart of the German industrial base, it’s reliance on a steady flow of cheap gas to fuel their operations, and just how ‘screwed’ (my word not his) they are if they can’t get it, or if they have to rely on LNG as opposed to pipes (go read the story for the nuance).

• Interestingly, the CEO of one of the Germany’s most important companies, BASF, came out a few weeks ago in an interview and said these somewhat chilling words which echo brilliantly Steven’s message in the above piece: “We’ve been naïve as a society because everything seems fine. These problems we have in Germany are accumulating. We have a period of change ahead of us; I don’t know if everyone realizes this.” This isn’t a politician, a media talking head, or a garage band hedge fund trader. This is the CEO of the largest chemicals company on earth. This is signal, not noise.

• In an almost laughable turn of events, BP, whose CEO Bernard Looney had pledged the most aggressive shift away from oil and gas in the industry back in 2020, has now done a strategic 180 “shifting its strategy to target more investment in both fossil fuels and low-carbon energy and relaxing near-term emissions goals in response to what it sees as a medium-term energy shortage. Under a new plan, BP will invest an extra $1 billion annually in oil and gas, as well as transition businesses through the end of the decade. Critically, it will maintain much higher oil and gas production.” I think they finally remembered their name is actually British PETROLEUM.

• The Swedish government has officially scrapped their green energy targets and is basically reworking their plans on their climate agenda. Why? As the Swedish Finance Minister Elisabeth Svantesson said simply, “we need a stable energy system.” She said wind and solar are too unstable, that they are shifting back to nuclear power, and that they have scrapped their 100% renewable targets. Lastly, and something Germany would be wise to listen to, she stated, “substantial industrialized economies… only a gas to nuclear pathway is viable to remain industrialized and competitive.”

• And lastly, as Anas Alhajji of Daily Energy Report puts it, “natural gas is NOT a bridge to the future, it is the future.”

Taiwan Arms Sales

One of the biggest geopolitical stories of this last month (the Russian Rebellion notwithstanding), was U.S. Secretary of State Antony Blinken’s trip to China, which was the first meaningful visit of an American diplomat to China since 2018, and one in which he met with his counterpart Qin Gang, and the big man, President Xi.

They hashed out a lot of issues but one pain point for China was that of U.S. arms sales to Taiwan.

The worst-kept secret in geopolitics is China’s desire for taking back the country they view to be rightfully theirs, the island nation of Taiwan. So, the U.S. supplying armaments that would seemingly make a military takeover more difficult, is something they would very much like to put an end to.

So how much does the U.S. sell to Taiwan? Turns out, not that much at all.

$140 million of U.S. arms imports (0.5% of Taiwan’s total imports) puts them at #21 on the list of the U.S.’s arms export partners.

Apparently, China wants that number at $0, but as it stands right now, ‘heavy hitters’ like Bahrain and Morocco import way more than Taiwan.

So maybe this story is more of a non-story that wants to be more of a story than it actually is…

The Oil Tug-o-War

U.S. Shale vs. OPEC+.

Private Markets + Political Incentives vs. Nationalized Oil.

Oil’s storylines run deep, and that’s why it’s so fascinating.

In the U.S. and much of the West, the two main constituents, oil companies and politicians, want two different things. Oil companies want high prices to make more money while politicians want low prices to keep inflation low so they can get re-elected, but not too low because energy is a national security issue, and they want their domestic producers to stay in business.

In nationalized economies, it’s much simpler – keep that price as high as possible.

And this is where oil becomes an interesting geopolitical story.

Quoting from Simon Watkins of Oilprice.com:

“Whilst Saudi Arabia and its OPEC brothers need oil prices as high as possible to fund these flights of fancy [i.e. the $500b Neom project], the direct opposite is true for the U.S. and its main allies in the West and the East. These countries are broadly net importers of oil and gas, so sustained oil prices above $80 per barrel(pb) of Brent, and corollary rising gas prices, mean that inflation will remain higher for longer, which will keep interest rates higher for longer, which will increase the economic damage done to them. For the U.S., these fears have very specific ramifications: one economic and one political. The economic one is that historically, every $10 pb change in the price of crude oil results in a 25-30 cent change in the price of a gallon of gasoline. For every 1 cent that the average price per gallon of gasoline rises, more than $1 billion per year in consumer spending is lost and the U.S. economy suffers. The political one is that, according to statistics from the U.S.’s National Bureau of Economic Research, since the end of World War I, the sitting U.S. president has won re-election 11 times out of 11 if the U.S. economy was not in recession within two years of an upcoming election. However, sitting U.S. presidents who went into a re-election campaign with the economy in recession won only one time out of seven. This is not a position sitting President Joe Biden, or the Democratic Party, wants to be in one year out from the next U.S. election.”

U.S. elections are right around the corner. OPEC has one more planned meeting this year in November. They already agreed to cuts. More may be coming. The Saudis and the Biden administration get along about as well as Elon and Zuck.

Game on.

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Here are a few snippets from last week's report:

On the Japanese Turnaround

Our View on the FOMC

The Chinese Demand Story

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